Is better insurance the answer to urban growth in vulnerable cities?

The UN predicts that by 2050, 70% of us will be living in urban areas. It was about 30% in 1950 and it’s split roughly 50/50 now. This trend means the size of our cities has been growing steadily. Climate change is one of the many factors that will sustain this trend in the coming decades. Slow onset events like drought and sea level rise, as well as sudden events such as hurricanes and floods are increasing the likelihood that people will leave rural locations and head for cities. But our growing cities are also at risk from other hazards linked to climate change. Coastal mega cities are at risk from sea level rise and increasing extreme weather events. People are moving from one high-risk area to another, or sometimes into areas of even higher risk.

Moving from the countryside into a city can bring a number benefits for a household, but can also expose people to new risks. If one family member moves to a city and finds work this can diversify household income and provide some financial security for their relatives who remain in rural areas. But there is no guarantee of work on arrival in a city. Many migrants move directly into slums with cramped conditions, poor sanitation and water supply leaving them vulnerable to infectious diseases. Poor construction and lack of urban planning also means slums are particularly vulnerable to storms, flooding and other natural hazards.

Apart from the human cost of these events, it also raises the question of how municipal authorities deal with enormous cost of these emergencies. Some argue that one way of meeting this challenge is the through insurance. In particular, the Asian Development Bank has suggested that a particular kind of insurance, Catastrophe Bonds (or Cat Bonds), could be part of the answer.

Cat Bonds are a way of re-insurance companies protecting themselves against the cost of massive disasters. Insurance companies realise that in the event of a major earthquake, flood or hurricane that the amount they would have to pay out as people claim on their insurance would bankrupt them. To protect themselves from this they would approach a re-insurance company. The insurer and reinsurer might agree that in the event of a major disaster, the insurance company will pay the first £1bn of claims, but if the total claims go over the £1bn limit, the reinsurance company will pay them. In return for this, the reinsurance company will take a small cut of every policy that the insurance company sells. Cat Bonds are used by reinsurance companies to protect themselves against the disasters when even they would struggle to meet their obligations to insurance companies.

The reinsurer would start by defining a very specific possible future catastrophe. For example a category 5 hurricane making landfall in Florida and directly hitting Jacksonville between January 2012 and December 2017. The re-insurance company would then approach investors and make them an offer: they pay perhaps £200m to the reinsurance company and in return get an attractive rate of interest. The investors agree to part with the money for a given period of time, perhaps five years. At the end of the five years, they get all their money back. They’ve also been receiving interest, so they’ve made a profit. But, if the specified catastrophe takes place, they lose all their money. The reinsurance company then uses the money to pay the insurance companies, who then use the money to pay the claims made by their policyholders.

As the rural to urban migration trend continues, could Cat Bonds help insure our growing cities against increasing natural hazards? Perhaps, but there are also a number of problems.

Catastrophe bonds only pay out if a very specific and clearly defined disaster takes place. If the actual disaster deviates even slightly from the one defined by the Cat Bond, the money is not released. For example, many reinsurance companies issued Cat Bonds covering themselves against an earthquake hitting Japan. When, in March 2011, an earthquake did strike Japan causing $34Bn in damage most Cat Bonds did not pay out. The epicenter was out at sea rather than directly under the main land and most of the damage was actually caused by the subsequent tsunami. This meant that most Cat Bonds were under no obligation to release money. One commentator suggested, “Catastrophe bonds have done a far better job protecting investors than they have providing a financial hedge to insurers.”

Could Cat Bonds help us extend insurance to people who are currently living uninsured in high-risk areas? As natural hazards increase, we can expect insurance to become more expensive. Cat Bonds help insurers and reinsurers pass on the risk of a big disaster, so could help bring the price of insurance down. However, it is also unclear what will happen to price of Cat Bonds as the cost of and frequency of climate related disasters goes up. What is clear is that rural to urban migration is likely to continue and the concentration of people in coastal cities does present a challenge. Some kind of insurance against natural hazards is needed for the infrastructure and for individuals in these cities. But, Cat Bonds should not be seen as a panacea that can provide that protection.